The Danish Tax Council has answered this in a new decision. The decision is particularly relevant for anyone who has ETH. But it is also relevant for anyone who has cryptocurrency that has undergone an upgrade, changes in rights and functionality or anything else that may indicate that a cryptocurrency has changed character to a degree that it should be considered disposed of.
On September 15, 2022, Ethereum transitioned from using Proof of Work (PoW) to Proof of Stake (PoS). PoW and PoS are two different mechanisms used to validate transactions on the Ethereum network. While PoW requires participants (miners) to use significant server power to solve complex mathematical problems to validate transactions and create new blocks, PoS relies on participants to 'stake' their ETH as a form of collateral to gain the right to validate transactions. This change is not only significant for significantly reducing network energy consumption, but it is also expected to improve network security and efficiency. By moving away from the energy-intensive mining process to a staking-based system, the Ethereum network can achieve a higher degree of scalability and faster transaction processing, which is crucial for its long-term sustainability and usability
In connection with the merge, Ethereum transitioned to a new blockchain: Beacon Chain. The question to the Danish Tax Council was thus whether this transition should be considered a realization for tax purposes. If so, all ETH should be considered to have been realized on September 15, 2022.
The realization principle originates from section 4 of the State Tax Act in conjunction with section 5(1)(a) of the State Tax Act. The realization principle determines the income year for an asset to be considered disposed of.
Realization can take place through sale or other disposal such as exchange, redemption or similar forms of transfer of rights. In other words, any exchange of cryptocurrency should be considered a realization for tax purposes.
The Tax Council considered a similar issue in SKM2023.306.SR, where they had to assess whether an upgrade of the cryptocurrency KNC, which was linked to KyberDAO, should be considered a realization. The Tax Council assessed that this was the case. In its assessment, the Tax Council emphasized that the upgrade resulted in a new token with improved functionality, including the introduction of a new possibility for KyberDAO to make future decisions on further and significant changes.
However, in the case concerning Ethereum's transition from PoW to PoS, the Tax Council found that no tax realization had occurred.
In its assessment, the Danish Tax Council emphasized that the "merger" into Beacon chain has not changed the actual basis of ETH, but that it is merely a technical change in the way in which transactions on Ethereum are validated. It is thus the same asset that does not undergo changes to a degree that results in a taxable realization.
The Tax Council's decision can be read here.
The Tax Council's decision means that ETH should not be considered realized in connection with the merger. This means that changes in value between the time of acquisition of ETH and up to September 15, 2022, when the merger was completed, are irrelevant to the income statement.
The decision is not surprising, as it confirms the already applicable practice, including in particular SKM2023.306.SR. However, the decision is interesting in the sense that it confirms that it depends on a case-specific assessment when a cryptocurrency is to be considered realized. Thus, it may be certain changes in rights and functionality that determine the difference.
It is our assessment that the legal assessment of whether a taxable realization has occurred has certain similarities with the assessment of when shares are deemed to have been disposed of in the event of amendments to the articles of association. Here, too, certain changes to the rights of the shares may result in transfer tax. As there is a wealth of administrative practice regarding the issue of transfer tax on capital shares, this practice can therefore be referred to as a supplementary interpretation contribution when assessing when a cryptocurrency is to be considered realized.
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